Efficient Market Hypothesis

Definition

The Efficient Market Hypothesis (EMH) suggests that financial markets are 'informationally efficient,' meaning that asset prices reflect all available information at any given time. This theory implies that it is impossible to consistently achieve higher returns than the overall market through stock picking or market timing because any new information is quickly incorporated into stock prices. EMH has important implications for investment strategies, suggesting that passive investing may be more effective than active management.

5 Must Know Facts For Your Next Test

1. EMH is categorized into three forms: weak, semi-strong, and strong, based on the type of information reflected in asset prices.
2. The weak form asserts that past price movements are reflected in current prices, while the semi-strong form includes all publicly available information.
3. Strong form EMH claims that all information, including insider knowledge, is reflected in stock prices, which has been widely debated.
4. The theory underpins the rationale for index funds and passive investment strategies, as it suggests active management cannot consistently outperform the market.
5. Empirical evidence for EMH varies, with some studies supporting its validity while others highlight instances where markets behave inefficiently.

Review Questions

• How does the Efficient Market Hypothesis challenge traditional investment strategies that rely on stock picking?
  • The Efficient Market Hypothesis argues that asset prices incorporate all available information, making it difficult to consistently achieve returns greater than the market through stock picking. This suggests that traditional investment strategies, which depend on analyzing stocks to identify undervalued securities, may be less effective. Instead, EMH supports passive investment strategies like index funds, which aim to match market performance rather than outperform it.
• Evaluate the implications of the Efficient Market Hypothesis for active versus passive investment management.
  • The Efficient Market Hypothesis has significant implications for both active and passive investment management. If markets are efficient, then active managers, who attempt to beat the market through research and stock selection, are unlikely to succeed over time after accounting for costs and fees. In contrast, passive management becomes more appealing as it seeks to replicate market performance without incurring high costs associated with active strategies. This creates a debate over the effectiveness of active management in light of EMH.
• Assess how recent developments in behavioral finance provide a counterargument to the Efficient Market Hypothesis.
  • Recent developments in behavioral finance highlight how psychological biases and irrational behaviors can lead to market inefficiencies, challenging the core assumptions of the Efficient Market Hypothesis. Factors such as overconfidence, herd behavior, and emotional decision-making can cause asset prices to deviate from their true values. These insights suggest that while markets may generally be efficient, they are not immune to irrational behaviors that can create opportunities for investors who recognize these patterns and capitalize on mispriced assets.

Related terms

Random Walk Theory: The theory that stock price changes are random and unpredictable, supporting the idea that past price movements do not influence future prices.

Arbitrage: The practice of taking advantage of price differences in different markets for the same asset, which is limited in an efficient market due to quick price adjustments.

Behavioral Finance: A field of study that examines how psychological factors and biases influence investors' decisions, often contradicting the assumptions of EMH.